Fair value under fire Financial crisis spurs debate over standardAs the financial community scrambles to regain the trust of investors angered by the Wall Street crisis, fair value accounting continues to come under fire.

Fair value accounting, or mark-to-market accounting as it's also called, requires financial firms to value assets based on what they could be sold for - transparency favored by both accountants and investors who claim that it gives a more accurate assessment of financial reality.

However, the practice has been demonized by Wall Street, which claims that the rule strong-armed banks and other financial institutions to report plunging write-downs as markets for mortgage-backed securities began evaporating.

Adding to that controversy was a provision contained in the $700 billion bailout package passed by both the House and Senate and signed by President Bush that gives the Securities and Exchange Commission the power to suspend fair value accounting.

Sources told Accounting Today that in early October, the eight largest accounting firms and the American Institute of CPAs met with SEC Chairman Christopher Cox to voice their opposition to suspending fair value accounting.

The accounting rule, whose roots date back to the 19th century, was shoved to the forefront by the staggering losses reported by financial firms on subprime assets that have led to a debate over the implementation of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 157, Fair Value Measurement, in circumstances where markets collapse and price inputs are readily available.

SFAS 157 was issued in 2006 and effective for financial assets and financial liabilities for statements issued for fiscal years beginning after Nov. 15, 2007.


SFAS 157 served to enhance disclosure requirements on previous fair value guidance, according to Vincent Gaudiuso, manager of the review department at Buchbinder Tunick & Co. LLP in New York. "From a practitioner's standpoint, I'm observing an implementation of a standard that went into effect this year and what the ultimate impact has been so far," he said, adding that the controversy has not been a surprise. "It may be to those who are outside of the financial world or the accounting world, but for the folks that are the CEOs of these institutions and certainly for public accountants and analysts, I think they had some sort of inkling there would be some significant write-downs."

The standard was one of the tender spots between troubled banking institutions, a variety of regulatory and investor advocacy groups, and legislators during the crafting of the controversial $700 billion rescue package.

A three-level hierarchy included in the standard addresses how preparers, as well as auditors, look to calculate a fair value, according to Charles Landes, vice president of professional standards and services at the AICPA. Level 1 addresses an observable input making an asset or liability easy to value. Level 2 explains what to do when there isn't an observable input of the actual asset or liability, but there are similar types of assets and liabilities in the market with which to compare. Level 3 addresses unobservable input where there are no assets or liabilities being traded and it can't be compared to something similar in the market.

"What we have today that is really creating all the problems is these inefficient, illiquid markets where there's no trading taking place anymore," Landes said. "So what has happened because the underlying assets of many of these securities - which is a mortgage and house value - have fallen so low, many of the assets being held by these investment banks on the books are being written down to an extremely low level. Do I look at Level 2 to try to value these things, or do I look to Level 3? Depending on which one you might use, you actually might get a higher value. It's really around that very technical point that this debate is occurring."


Bentley Stanton, CPA, CMA and a partner at Novogradac & Co. LLP in Alpharetta, Ga., said that while he doesn't believe SFAS 157 is the primary catalyst for the current financial crisis, application of the standard could exacerbate how financial instruments are valued.

"Under the new standard, certain financial instruments, specifically those with limited or no access in the public markets, may be required to be measured differently than perhaps they have been in the past," Stanton said. "This may perpetuate a write-down or impairment of the financial instrument sooner than expected. ... Furthermore, rash impulses in the market could further depress current values of both public and private financial instruments."

Michael Mard, CPA/ABV, ASA and president of The Financial Valuation Group in Tampa, Fla., compared the liquidity problem to a small grocer trying to do business with no cash in the till. There may be inventory, employees and even customers, but without cash in the cash register business will stop - until someone pays $10 for $9 worth of goods or the grocer takes $10 for $11 worth. He also said that the problem stems from a pile-up of derivatives with underlying disconnected collateral.

"Suspending fair value measurement standards is barking up the wrong tree," said Mard, who also serves on FASB's Valuation Resource Group, a committee responsible for identifying topics for FASB's staff to study. "Fair value is not the enemy; don't punish the referee for the fouls the players make."

Mard also said that the urgency surrounding fair value is "artificial and political."

"This problem occurred because banks and insurance companies and investment banks all kept giving away credit on the belief that everything would ultimately be paid by the underlying value in homes. When that didn't happen, the house of cards fell in," Mard said, adding that his views are his own and not those of the agency he serves. "It will take two years for the dust to settle."

Groups that support fair value accounting, such as the Center for Audit Quality, the Council of Institutional Investors and the CFA Institute, released a joint statement opposing suspension.

"Fair value measurement is really the only relevant information that's available in these current circumstances," said Kurt N. Schacht, managing director of the CFA Institute, a nonprofit organization comprised of investment professionals. "Any move to either suspend it or put a moratorium on fair value measurement would be a mistake in our view."

The AICPA, which publicly supported the passage of the economic stabilization bill, also is in line with the process of the SEC and FASB. "We support exactly what the SEC and the FASB are doing," Landes said. "We think they are doing the right thing in the sense that they ought to be looking at providing more guidance around those levels. It probably would have been very hard in 2006 when this standard was passed to think about the financial crisis that we are in today. Originally, this was premised on the notion that the standard works quite well when there are efficient markets. I think what they are doing now is certainly what is needed."

"In the interest of restoring investor confidence, the last thing we should do is deprive investors of the very information they find most useful," said Anita Ford, director of assurance services at Clifton Gunderson in Milwaukee, who is also a member of the Valuation Resource Group. "Instead, providing financial institutions with temporary flexibility in the capital adequacy requirements and taking steps to restore effective risk management in financial institutions are more direct and constructive ways of dealing with the current crisis."

Meanwhile, the board recently requested commentary on amending SFAS 157 "to clarify its application in an inactive market by providing an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that asset is inactive."

That commentary at press time was due October 9.


Aside from having the power to suspend the standards, which many in the banking community blame for the capital and credit crisis, the SEC has also begun a study to re-examine mark-to-market accounting.

The study is to be completed by Jan. 2, 2009, within the 90-day limit mandated by the bill, and will focus on the effects of mark-to-market accounting on a financial institution's balance sheet; the impacts of such accounting on bank failures in 2008 and on the quality of financial information available to investors; the process used by FASB in developing accounting standards; the advisability and feasibility of modifications to such standards; and alternative accounting standards to those provided in FASB 157.

The SEC plans to hold roundtables to get input from investors, accountants, standard-setters, business leaders and other parties for the study.


"FASB 157 did not contemplate the market that we have right now," said Donna Fisher, senior vice president of tax and accounting at the American Bankers Association, adding that her organization did not lobby for a suspension of the standards, only a clarification: "We have not asked for that from the FASB and the SEC."

Prior to President Bush signing the bailout legislation, the SEC and FASB issued a joint statement providing clarifications on fair value accounting specific to a volatile market. The clarifications address a number of questions that were cited as urgent, given the current financial climate.

Paul B.W. Miller and Paul R. Bahnson, professors of accounting at the University of Colorado at Colorado Springs and Boise State University, respectively (and regular columnists for Accounting Today), both agreed that the Sept. 30 statement was a reminder from the regulators of what fair value is and isn't. Fair value, according to the tandem, is quoted prices in orderly markets, but not when they are thin or otherwise reporting amounts that aren't representative of what would happen in contemporary transactions between "willing" buyers and sellers.

Pointing to the previously issued fair value hierarchy, the pair also agreed that when SFAS 157 was originally issued, elaborating on what fair values are and how to measure them, circumstances like those in today's markets weren't occurring.

"The bottom line for us is that neither FASB nor the SEC is stepping back from fair value," Bahnson said. "The release indicates that both are still committed to fair value measurement."

The ABA's Fisher said that SEC Chairman Christopher Cox provided "great leadership" by issuing the joint statement with FASB. She said the proposal is "very useful," clearly stating "that illiquid, disorderly market prices are an input to fair value, but are not determinative; that if there are no market participants, expectations of cash flows are the best evidence of fair value; that bright lines or 'safe harbors' are not generally accepted accounting principles; that a 'good Level 3' may be better than a 'bad Level 2;' that non-binding broker quotes are not necessarily determinative; and that the results of the disorderly transactions are not determinative when measuring fair value."


Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable, an organization representing 100 of the largest financial services firms that is working with the ABA, said that his group isn't necessarily against the fair value standard - but he was working with the SEC to "ease" the rule as it relates to illiquid assets in an uncertain market.

"We're for fair value accounting - it gives an accurate reflection of the value of the assets on the balance sheets to investors, to bond holders, to tax payers, etc. That's not what we're arguing for," he said. "We were worried that the intersection between the rule and the new stabilization law would artificially depress balance sheets and, as everybody is working to restore liquidity, it would have been an albatross inhibiting liquidity. The SEC clarification resolves this uncertainty and provides transparency and predictability to the valuation of assets."

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